The Use of ABX Derivatives in Credit Crisis Litigation

Abstract

In this article, we focus on the ABX indices, explain their economic functions, and explore how these indices are currently used in litigation related to the credit crisis. The ABX indices reflect important information for market participants, but a full understanding of the economics behind the indices is critical. Simple arguments and approaches about how the ABX indices should be used are bound to be flawed. The indices are meant as a publicly available measure of investors’ perception of the subprime market and their expectations about the expected defaults of the underlying mortgage collateral. But as the crisis unfolded and liquidity declined and even disappeared at various points, from not just the subprime market but all markets, the levels of the ABX indices reflected not just the increased default risk on the underlying referenced mortgages but also the increased perception of risk, lack of liquidity, increased uncertainty, and significant changes in the macroeconomic environment. It is critical to conduct careful analysis of the components of these ABX derivatives to properly use them as inputs in valuation.

TOPICS: Fixed income and structured finance, information providers/credit ratings